Optimal Monetary Policy

Abstract

Optimal monetary policy maximizes the welfare of a representative agent, given frictions in the economic environment. Constructing a model with two sets of frictions-costly price adjustment by imperfectly competitive firms and costly exchange of wealth for goods-we find optimal monetary policy is governed by two familiar principles. First, the average level of the nominal interest rate should be sufficiently low, as suggested by Milton Friedman, that there should be deflation on average. Yet, the Keynesian frictions imply that the optimal nominal interest rate is positive. Second, as various shocks occur to the real and monetary sectors, the price level should be largely stabilized, as suggested by Irving Fisher, albeit around a deflationary trend path. Since expected inflation is roughly constant through time, the nominal interest rate must therefore vary with the Fisherian determinants of the real interest rate. Although the monetary authority has substantial leverage over real activity in our model economy, it chooses real allocations that closely resemble those which would occur if prices were flexible. In our benchmark model, there is some tendency for the monetary authority to smooth nominal and real interest rates.

Optimal interest rate stabilization in a basic sticky-price model

“…We show that the widely used money-in-the utility function model (MIU) implies that Friedman's rule is optimal even when large amounts of price stickiness are present. This is in contrast to the key message of papers such as Woodford (2003a), Khan, King and Wolman (2003) and Uribe (2004, 2005) and others. Second, we find that the primary aim of optimal policy in the short run is to stabilize the nominal interest rate instead of inflation.…”

“…The other view considers optimal monetary policy in the short run in the presence of nominal rigidities and imperfect competition (e.g. Woodford, 2003a, ch.6-8;Benigno and Woodford, 2005;Khan et al, 2003;Uribe, 2004, 2005).…”

Tax distortions and the case for price stability

“…Hence, the popular HMT rule does not approximate optimal policy well. A similar conclusion is reached by Khan King and Wolman, [2003] (KKW henceforth).…”

“…Khan, King and Wolman (2003) show that while optimal policy may involve some sustained deflation, optimal price variation in response to various shocks is likely to be negligible.…”

News Shocks and Optimal Simple Rules

“…New Keynesians add nominal rigidities to the real business cycle framework to study the role of monetary policy in aggregate fluctuations but maintain the assumption of unpredictable random shocks. This is particularly true for the literature on the optimal design of monetary policy (see, among others, Clarida, Galí, and Gertler (1999), Svensson (1999), King, Khan, and Wolman (2003), or Woodford (2003)). …”